Quota Formula Reform is about IMF Credibility

The Euro crisis has overwhelmed all other debates about the reform and development of global governance institutions dealing with the World Economy.  It is therefore necessary to remind ourselves why we need a reform of the IMF Quota formula.  In one word it is all about the "Credibility" of the IMF in a rapidly changing World Economy.  Unless the power balance in the IMF changes to reflect the changes in the economic power in the World economy, the IMF will inevitably loose credibility as an "International" institution! Maybe my eye sight and hearing are not as strong as in my youth, but in the past year I have heard nothing (in the IMF or G20 setting) that would indicate that there is any recognition by the European Powers of the need for formula reform (and vote shares) to maintain credibility.

  The following table on the contribution of major economies to World growth during the past three decades encapsulates succicinctly the point about global change and credibity.  In the decade of the 1980s the US and Euro Area +  UK contributed over 1/5th each with Japan contributing about 1/10th.  In the decade of the 2000s the contribution of each of these had declined sharply with the USA contributing less than the 10% contribution of India, and all three together contributing about half that of China. The contribution of the Euro area+ UK has declined progressively from 20.6 percent in the 1980s to 17.3% in the 1990s to 6.4% in the 2000s.  This reflects a fundamental transformation of the World Economy and an emerging shift in economic power.  Unless this shift in economic power is reflected in the IMF an institution for monitoring/managing the global economy, it is not difficult to imagine it going the way of other UN institutions that have completely lost Global credibility and are increasingly being bypassed!.

Table	Contribution to World Growth
	1981 to	1991 to	2001 to	1981 to
	1991	2001	2011	2011
United States	21.2%	26.3%	9.6%	17.0%
Euro Area+ UK	20.6%	17.3%	6.4%	12.6%
Japan	11.4%	2.4%	1.0%	3.7%
China*#	8.7%	17.9%	29.6%	21.6%
India*#	4.4%	6.5%	10.1%	7.8%
Rest	33.8%	29.7%	43.4%	37.3%

There is one other very important fact that is often obscured, sometimes deliberately.  The contribution of the "Rest of the World" has increased by 10 per cent points from 33.8% in the 1980s to 43.4% in the 2000s.  A formula that fully reflects the changes in the Global economic power will add to the vote share of  the smaller countries, not reduce it!

    The US share of the World economy has declined from 23% in 1980 to 19% in 2010.  Yet they have wisely chosen to hold a little over 15% of the quota shares and continue to remain below their share of the World economy.  The Euro area + UK's share of the World economy has declined from 25% of total in 1980 to about 18% in 2010, while their calculated Quota share (CQS) is 27.5%. At the same time their share of total borrowing from the IMF has increased dramatically.  Three decades ago the rich countries had the money and controlled how it was lent to the poor countries who were the main borrowers.  The objective situation has now reversed with the rising powers perfectly willing to contribute as much as needed as long as their quota share is adjusted appropriately, while the major borrowers are the rich countries of Europe. The earlier arguments are therefore being turned on their head to justify the continued control of the European powers.  Unless the Quota Formula is changed to align the voting rights in the IMF to that of economic power in the global economy there is a danger of Global public opinion beginning to question the 'International' in IMF and to wonder whether it is the European Monetary Fund(EMF)?

Global Economy: Fiscal and Monetary Policy

For the last two years (see earlier blogs)we have emphasized that credibility of fiscal policy depends more on legal and procedural reforms that will lead to a steady and sustained reduction in the fiscal deficit over the medium-long term and less on an immediate drastic squeeze on expenditures.  Even in the few cases that the latter helps establish credibility about the former, the consequent reduction in growth will inevitably undermine the short term gains and shake the presumed “anchor.” This will inevitably require a moderation of the “excessive squeeze” and undermine any short term gains in credibility.  Thus even in the short term it is better to moderate the growth of consumption expenditures and fiscal transfers and to shift expenditures to productivity and growth enhancing investment expenditures.

In deciding on the appropriate fiscal-monetary policy mix, we have to distinguish, first between reserve currency countries,such as USA and others.  In the former case, there is a danger that a large part of the monetary expansion will transfer into rise in global commodity and asset prices, rather than enhancing domestic investment.  This is further exacerbated in the case of private consumption based on consumer credit as the failure to solve the Household mortgage problem early in the post-crises period, has resulted in  a deleveraging process that is much longer and more painful than it could have been with early action. 

In other countries, we have to again distinguish between countries constrained by currency union (e.g. EU) and those not so constrained.  In currency Union countries, self imposed constraints (EU on ECB) on monetary policy have exacerbated the crises.  Monetary policy was much tighter than it should have been. The recent loosening of monetary policy, has gone about half way to correcting the problem.  This process needs to be continued if the fear of contagion within the currency Union is to be eliminated.  The fiscal situation that matters in this case is the overall fiscal position of the currency Union, which is adequate to allow for a substantial further easing of the monetary policy approach, provided the debt of the insolvent countries is written off and all countries with tenuous fiscal situation make fundamental changes in their expenditure and tax policies to ensure future sustainability.

ECB Liquidity support for Euro Banks, Italy and Spain

In my blog of October 27th. I had stated (point 4)that only the ECB had to act like a normal central bank for the Euro area (i.e. provide unlimited liquidity in times of financial crisis) if basically solvent Euro countries were to be saved from becoming insolvent.  The best way would be to change the ECB constitution to allow it to do so (in parallell with changes to impose tough fiscal rules on Euro-countries).  This may however take too long to stave of a crises in the next 12 months.  One possibility that has been suggested is the issue of Euro Bonds.  However, it is unclear whether this has any greater feasibility till the fiscal rules have been changed by treaty.  There is however, an alternative that may be worth considering.
     National Banks within the Euro area, such as the German Bundesbank still exist, but do not have the authority to undertake monetary policy (interest rates) or to create money (Euros). This authority has been ceded to the European Central Bank (ECB).  They do, however, still have the capacity to issue euro bond to raise hard cash and their debts are still implicitly or explicitly guaranteed by their National governments. Thus these would have triple A rating in countries with a similar rating.  To the best of my knowledge, there is nothing barring the ECB from buying such bonds as part of any effort to increase liquidity in the Euro zone. The money raised in this way could in turn be used by the National Banks to create bilateral funding arrangements in the IMF.  Given the triple A rating of the IMF, this would preserve the triple A chain.  The funds could then be used to provide liquidity support to fundamentally solvent (even if currently stressed) Euro governments, under a fund program that ensures that these governments undertake the policy reforms that ensure debt sustainability (point 1 of Oct 27 blog).  Non-Euro area countries with a current account and trade surplus, such as China could also contribute to the bilateral fund in the IMF if they choose to do so.

How can the World help the Euro Group Save itself

    In my blog of October 27th I outlined the four critical steps for saving the Euro and the possible role of the IMF. In this note I focus on what the rest of the World can do to help, possibly through the IMF.  The IMF, given its expertise in enforcing fiscal and monetary discipline for restoring Balance of payment sustainability, has already been involved in helping the Euro-area governments enforce policy reforms (conditionalities) on Greece and Portugal for the support they are recieving from the Euro area (2/3rd) and the IMF (1/3rd).  This has however invloved the IMF providing unprecedented level of funds (100s and 1000s of times thier normal entitlement) and extrodinary fiscal support to soveregns that markets consider insolvent.  In principle the genuine and valuable role of the IMF in enforcing conditionalities on delinquent sovereigns can be provided with much lower levels of financial support, as was done historically in Latin America, Asia and other continents!

   From a global perspective the question is, what should the Rest of the World do to ensure that the Euro crisis is contained and any potential contagion to countries outside the Euro area minimised?  To answer this question it is essential to recognise that the World is currently suffering from a severe shortage of effective demand.  Thus there are two types of countries which are playing or should play different roles in diffusing the global crisis.  On one side are the current account and trade (goods and services) deficit countries who are making a net contribution to the global demand from the rest of the world, including the countries in crises.  Without thier continuing contribution there, it is impossible for the crises and near crises countries to reduce or eliminate thier current account deficits in the next few years. 

   On the other side are the current account and trade (G&S) surplus countries who are earning foreign income and accumulating foreign assets/ reserves.  These countries have the international resources to reallocate thier foreign earnings/assets into alternative channels, including to international financial institutions, to build a loan fund/buffer for ensuring that "innocent bystanders" hit by contagion from any euro-crises are provided adequate liquidity support.  It is thier obligation and duty to do so as long as they remain in surplus. One way of doing this is to contribute to a Bilateral loan fund in the IMF.  This would be fair and evenhanded contribution by all non-euro countries to help save the rest of the World from the negative contagion effects of the Euro crises and a potential melt-down of the Euro.  To the extent that some of these contributors are middle income countries, it would be legitimate to ask non-contributing rich countries to underwrite part of the risk. The precise nature of the contribution and the manner in which it should be used would ofcourse be need to be worked out in co-operation with the potential donors to this fund.

   In between these two types of countries, are an ambiguous type, which can contribute either through an increase in thier net purchase of goods and services from the rest of the World or through bilateral provision of funds to IFIs/IMF or a combination of the two, depending on thier thier income levels and reserve currency standing.

     Another source of funds for providing global liquidity could be fresh SDR allocations.  The conversion of SDRs into hard currencies by those in need of liquidity would have to be carefully circumscribed as long as the Euro crises lasts.  This is because a Euro-meltdown will result in a credit squeeze by European banks that is likely to lead to a sudden stop/capial outflow from emerging market economies.  Thus emerging economies with Current account and trade deficits who are dependent on foreign capital will become vulnerable even if they have substantial foreign exchange reserves.  Minimisation of contagion thus requires that these countries be shielded from demads for SDR conversions into free foreign exchange.  Any substantial new issue of SDRs should ensure this risk mitigation feature!

India: Poverty, Inequality and Inclusiveness

There has been a lot of stories in the Indian and international media about  "growing inequalities".  Every one has his own story about slums and Ambani palaces. Prominent International journals publish articles about the increase in "Indian" billionaires forgetting that many of them are citizens of UK and other countries, and their rise is more reflective of inequality in UK or these countries than in India!  A proper understanding of this issue requires an understanding of the key types of inequality.
    At the first level we must distinguish between income distribution and wealth distribution.  At one level, wealth is merely a an accumulation of savings from income and is likely to rise with income. However in a fast growing economy like India with shortages arising from failure of government policies and regulations, it can be a reflection of large and arbitrary changes in prices of assets.  The most visible and glaring instances in wealth inequality in India today are those arising from a stratospheric increase in land prices(higher in Mumbai and Delhi than in New York or Washington).  Anybody who owns or controls the limited supply of urban land in the fast growing cities of India, can become an instant millionaire or billionaire. Almost by definition this will change the wealth distribution adversely! The solution is to change the policies, regulatory systems and management of cities so as to rapidly increase the supply of habitable land.  this will bring down the price of land to a level that is appropriate for a lower middle income country that India is, so that a middle class person can afford to buy land.
   At the second level we have to distinguish between the distribution of private income/consumption and the supply of Public goods and services by the government.  Again the most glaring and visible inequality/inadequacies are in the supply of public goods and services.  The best example of these are the slums.  It is the lack of good roads, drains, clean drinking water, sewage and sanitation that hits you when you go into or even pass by one of the ubiquitous slums in every city of India.  This contrasts with the relatively orderly and clean appearance of the upper middle class and richer colonies.  The limited research done on the quality and distribution of basic public services in India suggests that it is among the worst in the world.  This what need correction most urgently. Further it is to a great extent linked to Urban governance and urban infrastructure issues, though village development also leaves much to be desired.
   An additional factor at the other end of the spectrum is resource rents (minerals-coal, iron ore, telecom spectrum) and rent seeking in Government procurement.  Such rents give windfall revenues to those who take leasing and contracting decisions and those who collude with them and thus worsen both the income and wealth distribution.  A simple situation is to institute a transparent auctioning procedure that ensure that any rents accrue to the State not to individuals.
  At the third level we have to distinguish between income poverty, hunger and malnutrition.  Even though the first two are related they are quite different from the third.  Though poverty reduction has been closely co-related with reduction in proportion of people who are hungry, the latter is completely unacceptable in modern India.  However, hunger is either located in isolated pockets or specially dis-advantaged people and the only way to eliminate it is to identify exactly where each hungry person is! Generalized solutions will not work quickly enough.  One of the purposes of the Multi application smart card (MASC) based on the Unique identification number (UID) that committee(s) chaired by me had proposed and worked out the operational plan, was to achieve this objective.
  On the other hand the problem of malnutrition is completely different problem from income or consumption poverty. It exists even among the non-poor and an increase in income or reduction in poverty will not automatically solve this problem.  On the other hand programs like the wheat-rice based Public Distribution System (PDS) designed for the poor seems to have accentuated the problem for both poor and near poor, by focusing excessive attention on stomach filling but not very nutritious cereals! My research has shown that there are two major causes of malnutrition.
   One is lack of public health and hygene i.e. clean water, drainage, sewage, sanitation and control of communicable diseases.  When a person (infant, child or teenager) has dyarheea no amount of food is going to reduce malnutrition.  The other is information and knowledge about personel health, hygiene and nutrition. In the old days before PDS, grand mothers and old wives tales passed down nutrition information gained over centuries through do's and don'ts on what foods items to consume and when has been lost, partly because of wrongheaded ideas that wheat and rice are better foods than locally available coarse cereals, berries, vegetables and obscure fruits.  The only thing that can be done now is to teach modern nutrition in schools and through public education campaigns and try to relate it to locally available produce, particularly in rural and semi-rural areas and to food labelling in urban and semi-urban areas.

Dealing with the Basic problem of Euro Debt vs Financial Engineering

Many imaginative, perhaps, even innovative approaches are being proposed for dealing with Euro crises. They contain a wealth of interesting ideas and mechanisms that can be useful in designing solutions.  There is a danger however, of getting lost in the minutiae of solutions and forgetting the basic fundamental economic problem that has to be addressed.     One of the most important lessons of the financial bubble and the subsequent financial crisis in the USA was that the slicing, dicing and recombining risk through levels and layers does not necessarily help risk diversification; it can as likely help to hide risk from innocent buyers of these products and make it easier to fool them into thinking that the risk has somehow dis-appeared.  In other words, the finest financial engineering cannot make the existing risk magically vanish, it can only hide it and confuse the naïve for a while.  Even the latter will be short lived as long as the memory of the financial crisis remains in the public mind! It is therefore useful to go back to the source(s) of the Euro crises and reiterate the essential economic measures that are required to diffuse the crisis!

There are five elements of any viable solution.  These are presented in their simplest form without bells and whistles, perhaps even in over simplified form in the light of the previous point.

(1)   Countries with unsustainable debt (GIIPS?) must put it on a sustainable path through a combination of fundamental reform of the expenditure, tax, transfer and growth policies.  The objective is to meet the sovereign debt sustainability condition [g-r+Pb > 0, where g = GDP growth rate, r = real interest rate on sovereign debt, Pb = Primary balance]. In this context it is important to remember that a fiscal squeeze by previously extravagant countries is not a morality play but an attempt to meet the debt sustainability condition!  Thus, beyond some point (the optimal) an immediate and sharp fiscal squeeze will reduce growth more than it increases the primary balance or reduces the real interest rate and thus make the fiscal situation less (not more) viable.

(2)   Greece (+Portugal?) is in a situation in which even the optimal policy mix outlined in (1) cannot put it in a sustainable path without debt restructuring.  In other words, Greece has been structurally insolvent for the past year or so.  The ‘grant’ funds needed to convert this problem from one of insolvency to one of liquidity must come from somewhere outside Greece - no amount of financial engineering can make this fact disappear.  Rough calculations suggest that a 60% haircut on Greek government debt would be sufficient to make Greece solvent.  It seems logical and fair that those who took the risk (or deliberately overlooked it) to earn higher returns (profits, bonuses) from Greece should pay when the risk materializes.

(3)   A Greek debt restructuring will have consequences for Euro area banks who have lent to Greece.  These consequences should have been anticipated and dealt with at least a year ago, by recapitalizing the banks.  The European Banking Authority now (reportedly) estimates these cost to be of the order of Euro 80 -100 bi (FT  Oct. 20, 2011).  To the extent that private investors are unwilling to raise the equity in these banks, the home country of these banks will have to provide the capital.  The 60% haircut on Greek debt presumably accounts for the indirect cost to the Greek Govt. of the effect of this default on Greek banks.  Other affected countries would also have to do the needful.  To the extent that the home country is not in a position to recapitalize, support is needed from outside the home country- the EFSF can be used to provide this additional support, either for direct financing or to underwrite repayments.  If the above estimate is correct, there will be money left over in the EFSF to strengthen the provisioning of bank loans to governments of countries that are on the border line of solvency, so as to remove doubts about potential contagion to these countries.

(4)   Once the direct and indirect effects of solvency problem are addressed, the borderline Euro area countries, such as Spain and Italy (along with Greece and Portugal), would be left with a liquidity problem.  If the ECB acted like a normal country central bank, such as the US FED, it could provide as much liquidity as needed to solve the liquidity problems of Spain and Italy.  As there is no explicit medium-long term grant element (once steps 1-3 are undertaken), there is no logical reason for not doing so in a period of low demand and low inflation (only ideology or primordial fear).  To the extent that mark to market accounting will impose temporary balance sheet losses on the ECB, the EFSF could be used to provide fiscal support till the markets stabilize and return to normal (at which point the ‘mark to market’ profits of ECB would revert to the EFSF).

A simple example illustrates.  Assume that the long term interest rate for a solvent Italy is the German rate +0.5%.  Because of all the problems outlined above, the premium above Germany has gone up to 2.5% (say).  Thus the ECB will be effectively picking up the risk equivalent to 2% points for debt coming due in the next 6 -12 months and will therefore constitute ‘mark to market losses’ in its balance sheet of this amount.  This fiscal cost has to be borne by the EFCF till the markets realize that the problems at 1-3 have been addressed (after which Italian interest rate will go back to the German rate +0.5%).  Thus the fiscal cost is borne by the EFCF not the ECB – with Euro 300 billion of Italian debt coming due in the next 12 months (in this example) the temporary fiscal cost to be borne by the EFSF will be Euro 6 bi).  The ECB provides the liquidity, whether directly or through Banks.

(5)  Finally for other non-Euro area countries that may be affected in the days/weeks/months following a Greek debt restructuring, the IMF must stand ready to provide liquidity support to “innocent bystanders”.  The IMF still has sufficient funds for this purpose, and these could easily be augmented to the needed extent, if prior action has been taken on points 1 to 4 above.

The longer the basic problems outlined above remain unaddressed, the more difficult they become to address, as private creditors gradually reduce their exposure to insolvent countries at the cost of official and multilateral lenders and borderline solvent countries are pushed over the line by rising interest rates.

Fiscal Sustainability: Economic Theory vs. Market Fashions

In discussions of Fiscal Policy and Fiscal vulnerability I have repeatedly (over the past 25 years) come across a clash between Economic theory and Market Fashions.  The use of the word “Fashion” might suggest to some a harmless diversion a matter for amusement or entertainment, but a proper understanding of the economics is critical to dealing with the fiscal crises that threaten the World today. Let me illustrate this with four points that have a bearing on Fiscal sustainability.

The first basic principle of economics is the debt sustainability condition: g – r - Pd > 0 (g is the growth rate, r the real interest rate payable on sovereign debt, Pd is the primary deficit).  A sovereign’s debt is sustainable if the growth rate exceeds the real interest rate paid on the debt by the extent of the Primary surplus.  With few exceptions (e.g. William Buiter of Citi), the public discussion of debt sustainability has been carried out without reference to this basic essential data.  Unfortunately this is not new: Over the past 25 years I have often seen even highly respected institutions such as the IMF ignore this simple number when it did not fit with their conclusions and recommendations (which therefore inevitably turned out to be wrong).  Market fashion has shifted dramatically away from this measure since an empirical paper estimated” that 60% was the safe level of gross debt to GDP ratio for every country under the sun.  Subsequent work concluded that this was the safe level for Developing countries but the safe level for Developed countries was higher (90%?).  I am sure that there will many subsequent revisions and refinements to these estimates.  I call this a fashion not because these estimates are not useful, but because it has led to herd behavior in which analysts do not even think it worthwhile to produce and present the basic numbers for the sustainability conditions. It would seem to me that we can easily produce this data, not only for the US, Japan and European countries currently under pressure but also other economies with weak fiscal situations and poorer economic data. This will allow us to define the relative fiscal sustainability of different countries more accurately and identify the source of the problem, the better to deal with it.

Economic theory tells us that, the debt that is relevant to the fiscal sustainability issue is the net debt (debt net of assets) not gross debt.  This is such a simple and well understood (by private individuals) principle of economics that it is almost embarrassing to raise it in a professional context.  Yet public discourse over the last two years barely ever mentions the asset side of the balance sheet or presents the comparative net debt position of countries under stress.  When financial markets sense a crisis, even a minor temporary one, only the short term matters, as each market participant tries to be the first to unload its holding of the concerned sovereign debt or loans.  Only the gross debt, coming due and needing refinancing seems to matter to the markets.  If this is true, why call it a ‘market fashion’?  Because it is the obligation and duty of responsible analysts, including the international financial institutions, to focus not just on the short term but also on the medium and long term – the original definition of “sustainability”.  The short term can be dealt with by liquidity support, whether from the Country’s Central Bank or the IMF, it is or should be the medium term that determines sustainability.

The theorists who emphasize Net debt are quite aware of the problem of maturity mismatch between sovereign debt and sovereign assets (e.g. loans or bond debt and public companies or infrastructure assets) and about the difference in risk associated with the different type of assets (e.g. physical assets versus future tax obligations).  This cannot distract from the basic economic fact that fiscal solvency depends on the net debt position – a country or individual cannot be insolvent if its assets exceed its debt. Further, the fact that a country’s fiscal situation (as against an individual’s) can be sustainable with debt larger than its assets matters even in the short term, because it is possible to loan or sell some assets (perhaps at a discount) to meet short term debt obligations! The safety threshold of 60% or 90% gross Debt-GDP ratio will surely be refined if we put in the effort to determine net debt.   To say that we do not have a perfect measure of sovereign assets or net debt is an evasion; imperfect measures (for instance physical assets valued at depreciated book value) are better than no measures, if we are clear and transparent about the limitations.

The theory also makes a distinction between sovereign debt financed externally and that financed domestically, though mostly in a very elementary manner of differential interest rates. Some of us who have had to advise on fiscal control and fiscal debt issues and to face the consequences of bad or incomplete advice, have long asserted that external financing of sovereign debt is not worth the risk.  The advantage of lower nominal interest is very tempting economically and politically: However the exchange risk is likely to be neglected or ignored and the danger of sudden stops and reversals is very real.  The country can suddenly find itself at huge risk from shocks to global financial markets and overreaction to temporary problems in the domestic economy and polity.  In addition the valuation of assets that go into the determination of net debt, is likely to be asymmetric – foreign lenders to the sovereign are likely to value it much less than domestic debt holders relative to debt.   Besides the home bias and exchange risk, other factors include differential costs of using the legal system.

Recent, preliminary empirical analysis also suggests that the net external debt of a country has a positive effect on the volatility of capital flows (i.e. higher net debt more capital flow volatility).  In other words the lower the cumulative gap between domestic investment and domestic saving (Id-Sd) the more stable capital flows are likely to be.  This implies that higher domestic private and household savings are likely to lead to lower capital volatility lower risk to foreign borrowing (private and government) and a higher threshold limit for safe Debt-GDP ratios. The hypothesis is that (other things being equal), higher domestic private saving rates allow a country to sustain higher Sovereign Debt-GDP levels.[1]  If this is true it would certainly be useful to know the relative household and private saving rates of different countries, along with the other data mentioned above.  We would then be in a better position to judge relative fiscal sustainability and to identify the key problems and  focus on the policies that can make a difference.

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[1] A currency union raises a host of other issues that need separate discussion.  The reference here is to countries with their own currency.